Why Index Funds Beat Actively-Managed Funds

Top Reasons to Choose Index Funds for Investing

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Why do index funds outperform actively-managed funds? Over long periods of time, index funds have higher returns than their actively-managed counterparts for several simple reasons.

Here are several reasons to buy index funds:

Index Funds Are Passively Managed

Index funds, such as the best S&P 500 Index Funds, are intended to match the holdings (company stocks) and performance of a stock market benchmark, such as the S&P 500.

Therefore there is no need for the intense research and analysis required to actively seek stocks that may do better than others during a given time frame.

This passive nature allows for less risk and lower expenses.

Index Funds Remove 'Manager Risk'

Fund managers are human, which means they are susceptible to human emotion, such as greed, complacency and hubris. By nature, their job is to beat the market, which means they must often take additional market risk to obtain the returns necessary to get those returns. Therefore, indexing removes a kind of risk we may call "manager risk." There is no real risk of human error with an index fund manager, at least in terms of stock selection.

Also, even the active fund manager that is able to avoid the trappings of their own human emotion can't escape the irrational and often unpredictable nature of the herd. As the famed economist John Maynard Keynes once said, "The markets can remain irrational longer than you can remain solvent." In other words, the most experienced fund manager with the greatest knowledge, skill and emotional control cannot consistently and successfully navigate the insanity of the crowd.

This craziness does not only apply to the downside of the market: Active fund managers often foresee a downturn in markets but they are early in their forecast and the markets continue moving upward for long periods after the fund manager has missed large positive returns.

Index Funds Have Low Expense Ratios

Mutual funds don't create themselves and those who offer mutual funds to the public need to receive some level of compensation for their efforts.

However, as previously explained in this article, index funds are passively managed, therefore the cost, expressed as an Expense Ratio, of managing the fund is extremely low compared to those funds that are actively engaged in beating the market averages. In other words, because index fund managers aren't trying to "beat the market" they can save you (the investor) more money by keeping management costs low and by keeping those cost savings invested in the fund.

Many index funds have expense ratios below 0.20%, whereas the average actively-managed mutual fund will can have expenses of around 1.50% or higher. This means, that on average, an index fund investor can begin each year with a 1.30% head start on actively-managed funds. This may not seem like a large advantage but even a 1.00% lead on an annual basis makes it increasingly difficult for active fund managers to beat index funds over long periods of time. Even the best fund managers in the world cannot consistently beat the S&P 500 for more than 5 years and a 10-year run of winning versus the major market indexes is almost unheard of in the investing world.

Index Funds Are Not Trendy

Index funds, especially the best S&P 500 Index funds, maintain large numbers of investors and high levels of investor assets.

They don't have sudden peaks or troughs in popularity or trendiness. This is a strength.

In contrast, many popular actively-managed mutual funds become popular because a fund manager has beaten the market averages consistently for more than a few years. As more and more investors become aware of the positive trend, the mutual fund attracts more assets (investor money). This can be negative in two ways: 1) The fund manager may be forced to buy more shares of larger sized companies or stocks that he or she wouldn't have purchased when the fund assets were smaller (this change is called style drift) and 2) The hot streak ends and investors move out of the fund in large numbers, which creates a liquidity issue (the manager has to sell stock holdings to create more cash for the exiting investors), which can create a drag on performance for those investors still holding the trendy fund.

Index Fund Investing Saves Time for Higher Priorities

One of the central ideas of investing in all categories of mutual funds is to make investing easier and more accessible to the average or beginning investor. However, choosing the best mutual funds can be time consuming, especially if the investor wants to invest only in a group of actively-managed funds.

Investing in index funds minimizes the time and energy spent on researching funds and managing the portfolio, which frees more time to spend on the priorities in life that the money you've invested is intended to enhance in the first place.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.